The Delights (and Terrors) Of Commodity Futures

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It is probably no accident that many of Bertram Schuster's clients are successful entrepreneurs. What he has to sell is not for those of modest means. Nor is it for the faint of heart.

Schuster is managing director of CSA Inc., a Chicago commodities brokerage firm, and his product is a managed commodities account. Give him at least $50,000 -- more if you wish -- and he will undertake to provide you with annual returns in the neighborhood of 30%. Just don't mortgage your house to get the money. On the way to such profits your equity may shrink by as much as one-third. And neither Schuster nor anyone else can guarantee that you will ever make a nickel.

The commodity futures markets have long been known as risky fields of play. Industry wisdom has it that anywhere from 65% to 90% of individuals investing in futures lose money, and stories abound of eager innocents who have seen $10,000 nest eggs turned into $20,000 debts almost overnight. The attraction, of course, is the potential profits that accompany such risk. Where else outside Las Vegas could an investor hope to hit a lucky streak -- and, like one recent winner, turn $5,000 into close to $200,000 in less than a year? Where else could a reputable broker even claim to be looking for 30% annual returns on anything like a regular basis?

The source of both risk and profit is not, as is commonly thought, huge swings in commodity prices. "There's no more volatility in the futures market than on the New York Stock Exchange," points out Robert Patton, research director of First Commodity Corp. of Boston. Rather, it is the fact that you can buy a lot of contracts with relatively little money. While many stock-market investors trade on margin, they can borrow only up to half the value of their purchases, and they must pay interest on the loan. To commodity traders, by contrast, a margin deposit is no more than a good-faith bond. The deposit can command up to 10 times its value in futures contracts, and no interest is paid on the balance.

This naturally leads to situations that are either immensely rewarding or immensely terrifying. If you invest $10,000 in $100,000 worth of wheat and wheat goes up 10%, you double your money. If it drops 10%, you lose your money. If it drops 30%, you lose three times what you put up, and you don't necessarily have any prospect of getting it back.

With so much leverage at work, it pays to know exactly what you are doing. That is why amateurs usually fare poorly in the futures market, and why no one is likely to advise you to dive in on your own. But it is also why the pros like Schuster and his cohorts have something to sell. A relatively recent invention, the managed commodities account is essentially an attempt to turn futures speculation from a take-a-flier-on-bellies gamble into a carefully planned long-term investment. Play the system right, so the theory goes, and you really can realize unusual returns. And since the Internal Revenue Service treats commodity profits more favorably than short-term stock winnings (60% of the total is considered long-term capital gains), you won't have to ship half your earnings off to Washington.

Managed accounts are offered by many different companies, and the mechanics vary. At CSA, Schuster and the firm's two founders, George Segal and Howard Abell, review the track records of independent commodity trading advisers all over the country, compiling a list of those that have turned in the best -- and most dependable -- performances. Their clients then select an adviser from the list and deposit their money with CSA, which in turn pays the adviser. The adviser gets an annual fee (usually 5% or 6% of the account's net asset value) plus an incentive fee of 15% to 20% of an account's net new profits, all more or less standard in the business. CSA gets brokerage commissions on trades ordered by the adviser, and in return keeps tabs on how the client's account is faring.

Other managed accounts rely on inhouse advisers or are set up by the advisory firms themselves. The latter arrangement, one trading adviser points out, enables the adviser to negotiate cut-rate fees with brokers, thereby saving clients up to 70% on each trade. Schuster argues that the arm's-length system maintained by CSA and many other brokers mininizes the potential for conflict of interest. Too often, he says, "the broker and the trading adviser wind up in bed together " ordering unnecessary trades on a client's account.

Whether or not you work through a broker, in any event, it is the adviser who has chief responsibility for making money for you. A few consider themselves fuandamentalists, scrutinizing every relevant detail of weather and economics and placing their bets accordingly. Many more are technical analysts, and the favored object of scrutiny is a computer screen programmed to reveal price-and-volume trends in individual commodities. The two approaches, of course, aren't mutually exclusive. "Watching the economy tells me that the price of copper sooner or later has to go up," Robert Patton explained late last fall. "But it doesn't tell me when to buy copper. That signal has to come from the price action on the market."

"Whatever their approach, traders don't care much whether their markets are moving up or down; they can make money as easily by going short (selling contracts) as by going long (buying contracts). Nor are they greatly concerned with the Dow Jones Industrial Average or most other market indicators, since most commodities rarely move in tandem with stocks or bonds.

What they do care about is being in the right place when a market begins a major move. Much of the time, the commodities markets are "choppy," moving up and down unpredictably, and as many as two out of every three trades lose money. But all those losses can be erased instantly when a market begins a longer-term trend. That, says Patton, is when an investment in futures can produce "mind boggling profits." Most advisers sprinkle their clients' money across several markets in hopes of being on board when a move begins -- although most also keep a substantial amount in cash or Treasury bills against the inevitable margin calls.

What to look for in an adviser? The first step obviously is to inspect track records, preferably with the help of someone knowledgeable about the industry. Volatility is all right, so long as average annual returns over a period of several years are attractive. One well-respected advisory firm, for example, reported losses for five straight quarters between mid-1982 and late 1983. But the same adviser had recorded a nearly unbroken string of gains for the previous three and a half years. In one dramatic quarter, his accounts had risen an average 24%.

Beyond the track record, experience is as useful in commodities as it is in any other business. "I deal with large numbers of the newer trading advisers," says Frank Pusateri, an industry consultant who specializes in evaluating advisers, "and it is just amazing that they all walk into the same pitfalls." One common failing is not knowing the times of day when there are likely to be only a few traders working in the pits. "When there are few people, the pricing is less competitive," Pusateri explains. "The guy who grows up with his computer walks into that one every time."

Then, too, it is nice to work with someone who sticks to a system. Otherwise, as First Commodity's Patton puts it, "human psychology comes into play." Suppose, he says, "you've convinced yourself that the price of copper is going up to $1.10, and you put your money behind that opinion. Now the market goes against you. You have to have the honesty with yourself to admit you're wrong and take the loss. If you're an adviser you have to have the courage to tell your client he's taken a loss. You might have a tendency to say, well, I hate to take another loss, just let me hang on till tomorrow."

Once an investor has an adviser, says Ted Thomte of Thomte & Co., an advisory firm in Boston, the investor should be willing to leave the money there for at least a year, and preferably longer. "This should be speculative money," Thomte notes, "but it should not be short-term money. Tell the trading adviser the rules, including how much he's allowed to lose before you want your money back. Then forget about it and let the guy do his job."

If he does it right, he won't run into trouble with Schuster or any other broker with whom he has marketing and transaction arrangements. CSA, says Schuster, builds in its own alerts and stop-loss orders, and usually shuts down its accounts if they lose one-third of their value. His clients, whose $50,000 minimum ordinarily represents no more than 15% of their overall portfolio, could probably afford the loss. But Schuster is selling an investment, not a gamble.

And on the upside? That may be where he is looking for an investor with an entrepreneurial spirit. "On the upside, you can talk pretty consistently about 30%, 35%, or more after fees and commissions, going back eight years or longer. With the favorable tax treatment accorded commodities, you've got an interesting investment vehicle there."

Last updated: Feb 1, 1984




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